Saturday, December 02, 2006

Active Portfolio Management

Is it possible to outperform the market? This is one of the most important questions any investor should ask. If your answer is no, if you believe the market is efficient, then passive investing or indexing - buying diversified portfolios of all the securities in an asset class - is probably the way to go. The arguments for such an approach include reduced costs, tax efficiency and the fact that, historically, passive funds have outperformed the majority of active funds.But if your answer is yes, it is possible to beat the market, then you should pursue active portfolio management. Among the arguments for this approach are the possibility that there are a variety of anomalies in securities markets that can be exploited to outperform passive investments, the likelihood that some companies can be pressured by investors to improve their performance , and the fact that many investors and managers have outperformed passive investing for long periods of time. But the active investor must still face the challenge of outperforming a passive strategy. Essentially, there are two sets of decisions. The first is asset allocation, where you carve up your portfolio into different proportions of equities, bonds and other instruments.These decisions, often referred to as market timing as investors try to reallocate between equities and bonds (see FIXED INCOME) in response to their expectations of better relative returns in the two markets, tend to require macro forecasts of broad-based market movements .Then there is security selection - picking particular stocks or bonds. These decisions require micro forecasts of individual securities underpriced by the market and hence offering the opportunity for better than average returns. Active investing involves being 'overweight' in securities and sectors that you believe to be undervalued and 'underweight' in assets you believe to be overvalued. Buying a stock, for example, is effectively an active investment that can be measured against the performance of the overall market.Compared to passive investing in a stock index, buying an individual stock combines an asset allocation to stocks and an active investment in that stock in the belief that it will outperform the stock index. In both market timing and security selection decisions, investors may use either technical or fundamental analysis (see TECHNICAL ANALYSIS, VALUE INVESTING and GROWTH INVESTING). And you can be right in your asset allocation and wrong in your active security selection and vice versa. It is still possible that an investor who makes a mistake in asset allocation, perhaps by being light in equities in a bull market, can still do well by picking a few great stocks.There are arguments for both active and passive investing though it is probably the case that a larger percentage of institutional investors invest passively than do individual investors. Of course, the active versus passive decision does not have to be a strictly either/or choice. One common investment strategy is to invest passively in markets you consider to be efficient and actively in markets you consider less efficient. Investors can also combine the two by investing part of a portfolio passively and another part actively.